Astonishing as it may seem given all the headlines about high UK public debt and fears about AAA credit ratings, Russell Investments argues that there is a big shortage of government bonds, especially those linked to inflation.

The problem is particularly acute at a time when the liabilities of pension funds are typically linked to investment-grade bond yields on instruments such as UK government bonds (gilts); as a result, pension funds are often forced by accounting rules to buy debt even at unattractive levels. There are, for example, around £1 trillion ($1.6 trillion) of liabilities of defined benefit pension schemes, a sum equal to the entire sum of gilts in issue, leaving little room for competing buyers, such as wealth managers looking to meet liabilities of their own clients.

“So today the cost of hedging liabilities is at an all-time high.  Derivatives can help supply levels, but prices are driven by gilts prices and are expensive at the long end,” said John Stannard, head of consulting, EMEA, at Russell Investment.

“We believe that it’s time to look beyond a focus on minimising short-term funding volatility. Of course liabilities should remain centre stage when determining the investment policy but we believe that investment-focused time is better spent on reviewing opportunities in the growth portfolio than fine-tuning the de-risking strategy,” he said.

“This means looking at risk in the portfolio overall and balancing those risks that cannot be eliminated (like interest rates) with risks that might be rewarded.  We believe that portfolios built in this way will hold a range of alternatives as well as core holdings of equity and fixed income,” Stannard continued.

The paradox of the supply-demand imbalance of debt despite fears about poor government finances has been noted by Barclays in its latest Equity Gilt Study, published earlier in February. It said demand for risk-free assets is outstripping supply, and that is even the case as government debt balloons in a number of countries, such as the US.

In fact, Barclays Capital argues that equity valuations are currently not out of sync with historic performance, although they are different from the bubble years of the 1990s. What is really different is that the supply of “safe” assets, as a share of world GDP, has fallen 5 per cent from 2002 through to 2007. Even though debt supply has subsequently increased and countries such as the US have lost their AAA credit ratings, demand for such safe assets is still strong.

The relative lack in supply of safe assets may be alleviated in the next few years, Barclays Capital argued, but the gap between such assets and demand, which amounted to around 35 per cent of GDP in 2002, will probably still exist, at around 12 per cent in 2016.